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Ateneo de Zamboanga University

School of Management and Accountancy


Accountancy Department

LEARNING PACKET
(FINMAN2) – (​FINANCIAL MANAGEMENT​)
Session 1, First Semester, SY 2020-21

LEARNING PACKET NO. 5 DATE: ____________________


TOPIC: COST OF CAPITAL Week No.: _____
Session: _____

I. CONCEPT NOTES
Overview
Working Capital Management and Finance
● Focused on the decision-making as to short investments and short-term financing
● While these may be important, the overall value of the shareholders’ wealth is not significantly
affected by short-term decision making but by the long-term ones

Long Term Decision-Making


● Financing and the cost of financing (Cost of Capital)
● Investment Decision (Capital Budgeting)

Capital Structure
• Composition of the total long-term capital employed in a firm
• Composed of the following sources:
✔ Long-term debt
✔ Preferred Stock
✔ Common Stock
Issuance of new shares
Retained Earnings

Goal of the financial manager- to be able to provide an ​optimal capital structure the considers all factors
that affects shareholder’s value while lowering the cost associated with its (cost of capital)

Factors affecting Capital Structure


• Revenue Stability
✔ Fixed payments are better than variable payments
✔ More predictable revenues can be used as leverage for financing
• Cash Flow
✔ Ability to generate cash to meet obligations
✔ Better cash flows warrant support any shift in capital structure
• Contractual Obligations
✔ Any constraint with current agreements
• Management Preferences
✔ Internal constraints on use of debt (risk aversion)
✔ Other internal constraints
• Control
✔ Preference on debt and preferred stock over common stock
✔ Issue of voting rights
• External Risk Assessment
✔ Market perspective of the firm
✔ Impact on share value and financial statements
• Timing
✔ General economic conditions that may affect cost of debt
✔ Reasonability of terms of agreement

Weighing Schemes
• Book Value versus Market Value
✔ Book Values are based on accounting values
✔ Market Values are based on the market

Market Value is preferred than book value because:


• Closely approximate to actual dollars from issuance
• Cost of capital is based on market values
• Cash flow is based on current and market values

• Historical Weights versus Target Weights


✔ Historical Weights are based on actual capital structure present
✔ Target weights reflect the desired capital structure proportion

Cost of Long-term Debt


● Long-Term debt:
✔ A debtor-creditor relationship between the firm (borrower) and another entity (lender)
✔ Entities may include:
Commercial Banks
Insurance Companies
Finance Companies
Private Entities

● Cost of long-term debt- ​EFFECTIVE INTEREST RATE

● Yield-to-Maturity Method
✔ A calculation method that estimates the cost of using long term debt
✔ Ways on computing the YTM rate:
Using a spreadsheet or financial calculator
Interpolation
Approximation Formula:
P ar V alue − N et proceeds
Interest + N o. of P eriods
Cost of Long-term Debt = P ar V alue + N et P roceeds
2

Where:
▪ Interest is the payment from the stated rate in a given period
▪ Par Value is the total value issued and stated in the bond
▪ Net Proceeds is the total cash received from issuance less ​flotation costs (costs of
issuing and selling securities)
• After Tax Rate
✔ Since the cost of debt (interest) is a deductible expense in taxation, therefore, an after-tax
rate will be determined to know the ​true​ cost of long term debt
✔ Computed as:
After-tax Cost of Long-term Debt = YTM Rate x (1 – Tax Rate)

Cost of Preferred Stock


• Preferred Stocks
✔ Stocks which give some preference as to dividends or assets over the other stocks
✔ For this discussion, the focus of preference is on the ​dividends

Stated Dividends
Cost of Preferred Stocks = N et P roceeds
Where:
▪ Stated Dividends – dividends stated in the stock certificate to be paid periodically
▪ Net Proceeds – cash received from issuance net of flotation costs

Cost of Common Equity


• Common Equity
✔ Shares that are residual interest in a corporation
✔ Sources of funds from Common Equity:
✔ Retained Earnings (current common shareholders only)
✔ Issuance of new shares
• Computation of Cost of Common Equity
✔ Capital Asset-Pricing Model (based on risk)
✔ Variation of Gordon Growth Model (based on return)

Gordon Growth Model


• Retained Earnings
= CurrentY Pear−end dividends
rice of Common Stocks
+ Growth rate
• Issuance of New Common stocks
= Current P rice ofY ear−end dividends
Common Stocks −F lotation Cost
+ Growth rate

Weighted Average Cost of Capital


• Cost of capital when more than one source of capital is being used
• Since costs depend on amount of capital to be employed, the cost of capital is dependent on the
weights given to each source of capital

Formula: = Σ (weight or proportion x cost of capital)

Retained Earnings breakpoint


✔ Preferred source of capital for common equity is retained earnings which is less costly
✔ However the funds tied up in the retained earnings is not unlimited unlike issuing
common stocks or other sources of capital, therefore, ​retained earnings breakpoint ​is
computed:

Amount of ​total capital that will act as threshold for when the company may use
retained earnings or instead issue new stocks
investment available f rom retained earnings
RE Breakpoint = weight or proportion of common equity

Indicates the limit of total capital needed where retained earnings can still be
used as source for common equity
Beyond the RE Breakpoint, company should already issue new common stock

Sources:
● Fundamentals of Financial Management by Van Horne, 13​th​ edition
● Fundamentals of Financial Management by Brigham and Houston, 11​th​ Edition
● Fundamentals of Corporate Finance by Berk, DeMarzo, and Harford, 4​th​ Edition
II. CHECKING FOR UNDERSTANDING

Exercise 1. ​Currently, Warren Industries can sell 15-year, P1,000-par-value bonds paying ​annual interest
at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for P1,010 each; flotation
costs of P30 per bond will be incurred in this process. The firm is in the 40% tax bracket.
1. Find the net proceeds from sale of the bond, ​Nd.
2. Use the approximation formula to estimate the before-tax and after-tax costs of debt.
3. Suppose instead that the interest is a semi-annual interest at the same coupon rate, what is the
after-tax cost of debt of the bonds?

Exercise 2. ​Your firm, People’s Consulting Group, has been asked to consult on a potential preferred stock
offering by Brave New World. This 15% preferred stock issue would be sold at its par value of P35 per
share. Costs incurred in relation to the issuance is P1 selling cost and P2 underwriting cost. Calculate the
cost of this preferred stock.

Exercise 3. ​Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently
selling for P57.50. The firm expects to pay a P3.40 dividend at the end of the year (2013). The dividends
for the past 5 years are shown in the following table:

Year Dividend
2012 3.10
2011 2.92
2010 2.60
2009 2.30
2008 2.12

Underpricing and flotation costs totaled P2.50.


• Determine the growth rate of dividends from 2008 to 2012.
• Determine the net proceeds, that the firm will actually receive.
• Using the constant-growth valuation model, determine the cost of retained earnings.
• Using the constant-growth valuation model, determine the cost of new common stock.

Exercise 4. ​A consultant gathered the following data for the construction of the capital structure of a
certain company:
Historical Target
Book Values
Long-term debt 50,000 10,000
Preferred Stock 10,000 20,000
Common Stock 40,000 120,000
Market Values
Long-term debt 45,000 15,000
Preferred Stock 15,000 40,000
Common Stock 60,000 125,000

1. How many weighing schemes are available and what are these combinations?
2. What is the optimal capital structure?

Exercise 5. ​FIGHTING Manufacturing is interested in measuring its overall cost of capital. The firm is in
the 35% tax bracket. Current investigation has gathered the following data:

• Debt ​The firm can raise debt by selling P1,000-par-value, 8% coupon interest rate, 5-year bonds
on which ​annual interest ​payments will be made. To sell the issue, the bond should be sold for 4%
lower than its par. The firm must also pay flotation costs of P22 per bond.
• Preferred stock ​The firm can sell 12% (annual dividend) preferred stock at its P120-per-share
par value. The cost of issuing and selling the preferred stock is expected to be P4 per share.
• Common stock ​The firm’s common stock is currently selling for P60 per share. The firm expects
to pay cash dividends of P5 per share next year. The firm’s dividends have been growing at an
annual rate of 4%, and this rate is expected to continue in the future. The stock will have to be
underpriced by P3 per share, and flotation costs are expected to amount to P2.50 per share.
1. Calculate the individual cost of the following sources of capital. For common stock, provide for the
two possible costs of capital.
2. Optimal capital structure is 40% debt, 15% preferred stock and 45% common stock. Using the
following data, what is the cost of capital for the following capital needs?
a. P300,000
b. P800,000
c. P500,000
3. If optimal capital structure is instead 50% debt, 20% preferred and 30% common stock, what is
the cost of capital given the three individual assumptions?

III. ANALYSIS
1. Discuss the importance of having an optimal capital structure.
2. Why does the firm’s capital have a cost?
3. What is the difference of nominal interest rate and effective interest rate?
4. In what instances is preferred equity better than ordinary/common equity?
5. Compare the Cordon Growth Model and the CAPM approach in computing the cost of common
equity.
6. Why is retained earnings a cheaper alternative than issuance of new shares?
7. What drives companies to diversify the sources of their capital?
8. How is the retained earnings breakpoint used in making capital funding decisions?

IV. INTEGRATION
1. When you need a large sum of money to buy something, where do you commonly get your
funding?
2. When choosing different sources of funding, what are the factors that you consider?

V. INDEPENDENT LEARNING

PREPARED BY:

________________________________________
[Course Code] Instructors